UK banks march towards nationalisation

The recent trading update of UK's largest domestic banking franchise, Lloyds Banking Group, which combines Lloyds TSB and the recently acquired HBOS, clearly underlines the severely weak state of UK economy and the significant problems and challenges facing the banking sector.

While Lloyds TSB traded profitably in 2008 and expects to report a profit before tax of some £1.3 billion (Dh6.9bn), the extent of HBOS's problems will see it report an underlying loss before tax of £8.5bn. Taking into account losses on sale of businesses and goodwill impairment, HBOS's loss before tax will be in excess of £10bn. Since the group's mid-December 2008 trading update, HBOS's 2008 trading has been further impacted by increasingly difficult market conditions, an acceleration in the deterioration of credit quality and falls in estimated asset values.

The key factors of HBOS's huge loss include the £4bn impact of market dislocation and approximately £7bn of impairments in the HBOS corporate division. The market dislocation has been driven by deterioration in asset quality and falling market valuations. The impairments reflect the acceleration in the deterioration in the UK economy, and is some £1.6bn higher than its expectations when Lloyds issued its shareholder circular at the beginning of November 2008. The estimated group's Core Tier 1 capital ratio at end 2008 is likely to be within the range of six to 6.5 per cent, which is relatively low.

The weakness and huge loss of HBOS questions the wisdom of Lloyds's acquisition of HBOS in late 2008. Lloyds TSB largely avoided the worst of toxic credit assets, has a diversified loan book and its funding profile was relatively sound. In contrast, HBOS's loan book was quite heavily concentrated towards the property sector combined with a large reliance on wholesale funding.

UK lending activity remains static due to the very weak domestic economy. At the time of the acquisition, Lloyd's management believed lending volumes would continue at the rates then apparent. However, this has proven to be overly-optimistic.

Margins have also tightened as interest rates have fallen sharply. Wholesale funding costs, including funds obtained under the UK Government guarantee, remain high relative to base rate and by historical standards.

Loan arrears across the retail, commercial and corporate sector continue to increase. In light of the worsening economic climate, trends in impairment charges are likely to come under further pressure. On the corporate side, higher provision charges reflect an increase in the migration of exposures into the higher risk and impaired categories and sharp declines in asset values with a consequent impact on estimated recoveries. These factors are expected to continue to impact results in the medium term.

Global market and economic conditions, UK recession and increasing unemployment will continue to present a particularly challenging operating and credit environment. These factors will impact on Lloyds Group capital ratios.

The trading update figures were certainly worse than expected and calls into question whether Lloyds Group will remain independent. The government already owns 43 per cent of the banking group but the results and outlook in the short-term makes it more likely that the government will inject further money and take a majority stake in Lloyds Group. The bank's recent sharp share price fall reflects in part that the market believes it is more likely that the bank will be nationalised. The pressure on earnings and capital point to a further capital raising in the short term.

At the time of Lloyds takeover of HBOS, shareholders feared Lloyds was heading for potential state control by buying the problem bank, while the entire banking sector was in crisis.

Speaking at the week-end's G7 finance ministers meeting in Rome, the UK chancellor tried to diffuse the question of whether Lloyds would be nationalised, stating that banks were best left independent and in the commercial sector. However, Lloyd's future is very much under a spotlight. Anymore pressure on its share price may force the UK Government to take a controlling stake in the bank. Ironically, both banks may be in better shape if the forced merger had not had happened with HBOS a fully government-owned bank and Lloyds TSB remaining independent. However, the hastily arranged takeover did happen and this may lead to a full nationalisation of the institution.